Who Pays For All This?
During its last fiscal year (October 2019 to September 2020), the U.S. government spent $6.6 trillion but only had $3.4 trillion of income. We had a deficit of $3.1 trillion and we are on pace to do it again, or worse. When the U.S. government runs a deficit it needs to borrow money to finance it. However, there are not enough buyers to finance a $3+ trillion deficit without interest rates skyrocketing and crushing the economy. If it absolutely had to be financed by investors, then rates would have to keep rising higher and higher and higher to induce investors to sell other assets (stocks, corporate bonds, etc.) to buy more U.S. Treasury bonds.
The question that needs to be asked by the individual who does not invest his or her own savings and who does not closely follow markets (i.e., my clients) is, “How does the U.S. government then finance these deficits?” The answer is that the Federal Reserve (“Fed”) creates new money electronically and buys them from the market. Seems magical doesn’t it.
Stocks are Going Higher
When investors sell bonds to the Fed they get to do something else with the money. This is one reason why the stock market soared last year after one of the worst crashes in history. The Fed continues to buy $120 billion of bonds per month from the market.
If I own a bond it means I have leant some government or company money. If the Fed buys the bond from me, then I can lend to someone else or buy stocks with it.
Commercial banks are not lending which is bad for economic growth, but the Fed—by continuing to buy bonds—is enabling credit creation and they are doing so at such a high rate that this is overriding the negative effect of regular banks not doing it.
So while just about everything else in the U.S. seems like a complete disaster, stocks are set to continue to rise because credit is flowing. They may fall temporarily, but if the current conditions remain, they will continue higher. (For more detailed coverage of this topic, see my recent True Vine Letter titled, 2021 Outlook: This Market Is Going Higher.)
There Has to be a Catch
The U.S. Congress does a good job of spending money. They might spend even more this year forcing the Fed to buy even more. If they spend too much though, and especially if they do so as the economy strengthens, then there will be too much demand chasing too few goods and then we will start to get inflation.
Inflation can get serious if people start to lose confidence in the government, the purchasing power of the money, and the system in general. We are not there and I hope we do not get “there” but let’s just say that we are not moving in the right direction.
Looking out over a multi-year horizon, I suspect we will get some inflation, then an economic shock, followed by a period of more serious inflation. This is not a prediction. I am simply being transparent about the framework I have in mind based on all the variables at play.
If you go back to the first 2 paragraphs of this letter and read between the lines, you can ascertain that the Fed is already colluding with the U.S. Treasury and the U.S. Congress to support this excessive amount of borrowing. The Treasury has to be certain that the Fed will step in and buy or else such excessive borrowing would cause a financial crisis as interest rates spiral out of control. To quote John Loeffler of Steel on Steel, “Socialist party ‘D’ & Socialist party ‘R’” could take things too far, investors could lose confidence in the system, and inflation could get out of hand. This is a serious risk that many professional investors are contemplating.
Strategy
Your portfolios are invested in individual stocks that I have conducted in-depth research on. Most of them are doing quite well right now and I expect this to continue for the time being. You also own some bonds, but not those that will get hurt by an excessive spike in interest rates. Bonds add balance to a portfolio and can potentially reduce risk. You also hold some cash that I will invest as opportunities arise. It is important to be able to take advantage of the bargains that arise when the stock market stumbles and more so when it falls. Holding some bonds and cash allows me to do this.
Finally, I am gradually deploying money into strategic assets that will do especially well if we get higher inflation. My expertise in mining is serving me well in this environment because metals shine under such conditions. The greatest risk retirees face is inflation. It can wipe out a conservative portfolio. Many are not prepared for this potential outcome.
Thank you for your business.
Joshua Hall